Current Scenario of Derivatives market in India

A DISSERTATION SUBMITTED IN PARTIAL FULFILLMENT

OF THE REQUIREMENTS FOR THE AWARD OF

MBA DEGREE OF BANGALORE UNIVERSITY.

SUBMITTED BY

Md Masood Khan

Reg. No � 04XQCM6052

UNDER THE GUIDANCE OF

Dr. N.S. Malavalli

M. P. BIRLA INSTITUTE OF MANAGEMENT

(ASSOCIATE BHARATIYA VIDYA BHAVAN)

BANGALORE � 560001

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DECLARATION

This is to certify that the project titled �Current scenario of Derivatives market

in India� submitted by me in partial fulfillment of the requirement of Master of

Business Management course, is based on research work done by me under the

guidance of Dr. N.S. Malavalli , Principal, M. P. Birla Institute of Management.

This project has not previously formed the basis for the award of any degree or

diploma.

Place: Bangalore Md Masood khan

Date:

CERTIFICATE

I hereby certify that the research work embodied in the dissertation entitled

�Current scenario of Derivatives market in India� has been undertaken and

completed by Md Masood Khan under my guidance and supervision.

I also certify that he has fulfilled all the requirements under the covenant

governing the submission of dissertation to the Bangalore University for the

award of MBA degree.

Place: Bangalore (Dr. N.S. Malavalli)

Date:

CERTIFICATE

I hereby certify that this dissertation is an offshoot of the research work

undertaken and completed by Md Masood Khan under the guidance of, Dr. N.S.

Malavalli Principal of M.P.B.I.M. Bangalore.

.

Place: Bangalore (Dr. N. S. Malavalli)

Date: Principal, MPBIM

ACKNOWLEDGEMENTS

I am happy to express my gratitude to Dr. N. S. Malavalli, (Principal, M. P. Birla

Institute of Management), for his encouragement, guidance and many valuable

ideas imparted to me for my project.

I extend my sincere thanks to Dr. N. S. Malavalli principal MPBIM, Bangalore for

providing me all the information required and the guidance throughout the project

without which this project would not have been possible.

I would also like to sincerely thank all my lecturers and my friends for their help in

completing my project successfully.

CONTENTS

Particulars Page no

Declaration

Acknowledgements

Certificates

Research Abstract 01

Introduction 03

Review of Literature 06

Methodology 39

Presentation & Analysis 40

Findings & Conclusion 66

Terminologies 70

RREESSEEAARRCCHH EEXXTTRRAACCTT

A derivative instrument, broadly is a financial contract whose payoff structure

is determined by the value of underlying commodity, security, interest rate, share price

index, exchange rate, oil price, or the like. So a derivative is an instrument which derives

its values from some underlying variable /asset. A derivative instrument by itself does not

constitute ownership. It is, instead, a promise to convey ownership.

All derivatives are based on some �cash� products. The underlying asset of a

derivative instrument may be any product of the following types: -

1. Commodities (grain, coffee, beans, orange juice etc.)

2. Precious metals (Gold, Silver, Copper)

3. Foreign exchange rate

4. Bonds of different types including medium to long-term negotiation debt

securities.

5. Short term debt securities like T- bills

6. Over the counter (OTC) money market products such as loans or deposits.

Financial derivatives came into the spotlight along with the rise in uncertainty of

post 1970, when the US announced an end to the Breton Woods System of fixed

exchange rates leading to introduction of currency derivatives followed by other

innovations, including stock index futures.

Indian-capital markets have gone through a remarkable transformation in

last ten years. In these years, Indian capital markets have been witness to more than

100% increase in the companies listed on stock exchanges emergence of Securities and

Exchange Board of India (SEBI) as a truly national level of securities regulator, free

pricing of public issues, screen based trading systems, more than six times increase in the

turnover the stock exchanges, emergence of self regulatory organization in the fields of

merchant banking, mutual funds, emergence of investors associations, implementation of

trade guarantees besides others.

IINNTTRROODDUUCCTTIIOONN

BACKGROUND OF THE STUDY

The evolution occurred in stages. The Chicago Board of Trade (CBOT), which

opened in 1848, is, to this day, the largest futures market in the world. The general rules

framed by CBOT in 1865 became a pacesetter for many other markets. In 1870, the New

York cotton exchange was founded.

The London metal exchange was established in 1877 and is now the leading

market in metal trading (both spot and forward). Thereafter many new futures market

were started. The first financial futures market was the international monetary, founded in

1972 by the Chicago mercantile exchange. The London international financial futures

exchange followed this in 1982.

As already mentioned, some form of forward trading probably existed in India

also. The first organized forward markets came into existence in India in the late 19th and

early 20th century in Calcutta (for jute and jute goods) and Mumbai (for cotton).

Chronologically, India�s experience in organized forward trading is almost as long as

that of the United Kingdom, and certainly longer than many developed nations. However,

the tidal wave of price control, nationalization and state intervention in markets, which

swept through all economic policy making after independence, led to a rapid decline in

number of futures markets. Frequently markets were closed due to the feeling that they

were responsible for sudden movements of price in the commodities.

Statement of the problem

The problem is to analyze Derivative ways of minimizing the Risk in Indian Capital

market and to analyze the current scenario of Derivative markets in India.

Need and Importance of the Study

World financial market has witnessed a spectacular change in the field of

derivative markets in the past one decade, especially in the field of option, futures and

swaps. India also could not become aloof from the world trend and mainly after the

liberalization has set in motion. India introduced the different types in phased manner. A

derative market has gained momentum since its introduction in India and has played a

major role in Indian financial markets. Today the derivative volume in India is Rs. 25000

crores. In this context the study of Current scenario of Indian derivative market is very

contextual and important as well. That is why this subject is the topic of this dissertation.

Similarly, on the equity market, many retail investors who are uncomfortable

about the equity market would enter if they were given the alternative of buying

insurance, which controls their downside risk. This would enhance the action of the

savings of the country, which are routed through the equity market. More importantly,

derivative is one of the important tools of hedging risk. Therefore, the study of current

scenario of derivative market in India is very importance.

Objectives of the Research

The main objectives of the project are as follows: -

To study the current scenario of derivatives market in India.

To analyze whether the purpose for which derivatives are used has actually been

achieved.

To study the concept of derivatives and the purpose for which financial institutions

adopt derivatives.

Limitations of the study

The study is conducted in Bangalore only.

Since the study covers the overview of derivatives market, it cannot be generalized.

Data collected is only from secondary sources.

RREEVVIIEEWW OOFF LLIITTEERRAATTUURREE

PURPOSE

Literature review is one of the prime parts of dissertation. The very basic purpose

of the literature review is to gain insight on the theoretical background of the research

problem. It helps the researcher to gain strong theoretical basis of the problem under

study and also helps to explore whether any one has done research on the related issue.

That�s why literature review helps one to find out the path of problem solving.

In this regard, the very basic purpose of literature review in this dissertation is

same as mentioned above.

METHODOLOGY

For simplicity, the literature review has been divided into the following parts.

Definition of derivatives

Perquisites for derivatives market

Types of Derivatives

Derivatives market in India

Type of Options

DEFINITION OF DERIVATIVES

Derivatives are the financial instruments, which derive their value from some

other financial instruments, called the underlying. The foundation of all derivatives

market is the underlying market, which could be spot market for gold, or it could be a

pure number such as the level of the wholesale price index of a market price.

�A derivative is a financial instrument whose value depends on the

value of other basic underlying variables�

John c hull

According to the Securities Contract (Regulation) Act, 1956, derivatives include:

A security derived from a debt instrument, share, and loan whether secured or

unsecured, risk instrument or contract for differences or any other form of

security.

A contract, which derives its value from the prices or index of prices of

underlying securities.

Therefore, derivatives are specialized contracts to facilitate temporarily for

hedging which is protection against losses resulting from unforeseen price or volatility

changes. Thus, derivatives are a very important tool of risk management.

Derivatives perform a number of economic functions like price discovery, risk

transfer and market completion.

The simplest kind of derivative market is the forward market. Here a

buyer and seller write a contract for delivery at a specific future date and

a specified future price. In India, a forward market exists in the form of the

dollar-rupee market. But forward market suffers from two serious problems;

counter party risk resulting in comparatively high rate of contract non-

compliance and poor liquidity.

Futures markets were invented to cope with these two difficulties of forward

markets. Futures are standardized forward contracts traded on an organized stock

exchange. In essence, a future contract is a derivative instrument whose value is derived

from the expected price of the underlying security or asset or index at a pre-determined

future date.

PREREQUISITES FOR DERIVATIVES MARKET

There are five essential prerequisites for derivatives market to flourish in a country.

a) Large market capitalization

At a market capitalization of near $1.5 trillion, India is well ahead of many other

countries where derivatives markets have succeeded.

b) Liquidity in the underlying

A few years ago, the total trading volume in India used to be around Rs-300

crores a day. Today, daily trading volume in India is around Rs-15000 crores a

day. This implies a degree of liquidity, which is around six times superior to the

earlier conditions. There is empirical evidence to suggest that there are many

financial instruments in the country today, which have adequate to support

derivative market.

c) Clearing house that guarantees trades

Counter party risk is one of the major factor recognized as essential for

starting a strong and healthy derivatives market. Trade guarantee therefore

becomes imperative before a derivatives market could start. The first

clearinghouse corporation guarantees trades have become fully functional from

July 1996 in the form of National Securities Clearing Corporation (NSCC). NSCC

is responsible for guaranteeing all open positions on the National Stock Exchange

(NSE) for which it does the clearing. Other exchanges are also moving towards

setting up separate and well-funded clearing corporations for providing trade

guarantees.

d) Physical infrastructure

India�s equity markets are all moving towards satellite connectivity, which

allows investors and traders anywhere in the country to buy liquidity services from

anywhere else. This telecommunications infrastructure, India�s capabilities in

computer hardware and software, will enable the establishment of computer system

for creation of derivatives markets. Setting up of automated trading system as an

experience with various prospective exchanges will also be beneficial while setting

up the derivative market.

e) Risk-taking capability and Analytical skills

India�s investors are very strong in their risk-bearing capacity and can cope

with the risk that derivatives pose. Evidence of the volumes traded on the capital

markets, which are akin to a futures market, is indicative of this capacity. In contrast,

in some other countries, investors simply lack the risk-bearing capacity to sustain the

growth of even the equity market. It is expected that such a barrier will not appear in

India.

On the subject of analytical skills, derivatives require a high degree of

analytical capability for many subtle trading strategies to pricing. India has an enormous

pool of mathematically literate finance professionals, who would excel in this field.

Lastly, an obvious advantage for the Indian market is that we have enormous

experience with futures markets through the settlement cycle oriented equity which is not

truly a spot market but a futures market (including concepts like market-to-market

margin, low delivery ratios, and last-day-of settlement abnormalities in prices). We also

have active futures markets on six commodities. With this state of development of the

capital markets it is felt that there is no major hurdle left for the creation of development

of the capital markets. Hence on July 2, 1996 the SEBI board gave an in principal

approval for the launch of derivatives markets in India.

Types of Derivatives

DERIVATIVES

FORWARDS

FUTURE

OPTIONS

SWAPS

One form of classification of derivatives is between commodity derivatives and

financial derivatives. Thus futures, option or swaps on gold, sugar, jute, pepper etc are

commodity derivatives.

While futures, options or swaps on currencies, gilt-edged securities, stock and

share stock market indices etc are financial derivatives.

Types of Derivatives

Derivatives

Forwards Future OptionSwaps

Commodity

Security

Commodity Security Call Put

Interest rate

Currency

A) OPTIONS:

The concept of options is not new one. In Fact, options have been in use for

centuries. The idea of an option existed in ancient Greece and Rome. The Romans wrote

options on the cargo that were transported by their ship. In the 17th century, there was an

active option markets in Holland. In fact, options were used in a large measure in the

�tulip bulb mania � of that century. However, in the absence of mechanism to guarantee

the performance of the contract, the refusal of many put option writers to take delivery of

the tulip bulb and pay the high prices of the bulb they had originally agreed to, led to

bursting of the bulb bubble during the winter of 1637.A number of speculators were

wiped out in the process.

In India, options on stocks of companies were illegal until 25th January 1995

according to sec. 20 of Securities Contracts (Regulation) Act, 1956. When Securities

Laws (Amendment) Act, 1956 deleted sec. 20, thus making the introduction of options as

legal act.

An options contract is an agreement between a buyer and a seller. Such a contract

confers on the buyer a right but not an obligation to buy or sell a specified quantity of the

underlying asset at a fixed price on or up to a fixed day in the future on a payment of a

premium to the seller. The premium paid by the buyer to the seller is the price of an

option contract

Options on a futures contract have added a new dimension to future trading like

futures options provide price protection against adverse price move. Present day options

trading on the floor of an exchange began in April 1973. When the Chicago Board of

trade created the Chicago Board Options Exchange (CBOE) for the sole purpose of

trading Options on a limited number of NEW YORK STOCK EXCHAGE listed equities

B) FORWARDS:

A forward is an agreement between two parties to exchange an agreed quantity of

asset at a specified future date at a predetermined price specified in the agreements. The

parties concerned agree the settlement date and price in advance. The promised asset may

be currency, commodity, instrument etc. It is the oldest type of all the derivatives. The

party who promises to buy but he specified asset at an agreed price at a fixed future date

is said to be in the �Long position � and the party who promises to sell at an agreed price

at a future date is said to be in � short position�.

C) FUTURES: It is similar to the forward contract in all the respect. In fact, a future is a

standardized form of forward contract. A future is a contract or an agreement between

two parties to exchange assets / currency or commodity at a certain future date at an

agreed price. The trader who promises to buy is said to be in � long position � and the

party who promises to sell said be in �short position�.

Futures contracts are contracts specifying a standard volume of a particular

currency to be exchanged on a specific settlement date. A future contract is an agreement

between a buyer and a seller. Such a contract confers on the buyer an obligation to buy

from the seller, and the seller an obligation to sell to the buyer a specified quantity of an

underlying asset at a fixed price on or before a fixed day in future. Such a contract can be

for delivery of an underlying asset.

To eliminate counter party risk and guarantee traders, futures markets use a

clearing house which employs initial margin, daily market to market margin, exposures

limits etc. to ensure contract compliance and guarantee settlement standardized futures

contracts generate liquidity. In addition, due to these instruments being traded on

recognized exchange�s results in grater transparency, fairness and efficiency. Due to

these inherent advantages, futures markets have been enormously successful in

comparison with forward markets all over the world

The difference between forward contract and future is that future is a standardized

contract in terms of quantity, date and delivery. It is traded on organized exchanges. So it

has secondary markets. Future contract is always settled daily, irrespective of the

maturity date, which is called marking to the market.

D) SWAP:

Swap is an agreement between two parties to exchange one set of financial

obligations with other. It is widely used throughout the world but is recent in India. Swap

may be interest swap or currency swaps.

Swaps give companies extra flexibility to exploit their comparative advantage in their respective borrowing markets.

Swaps allow companies to focus on their comparative advantage in borrowing in a single currency in the short end of the maturity spectrum vs. the long-end of the maturity spectrum.

Swaps allow companies to exploit advantages across a matrix of currencies and maturities.

DERIVATIVES MARKET IN INDIA

Prior to liberalization, in India financial markets, there were only a few financial

products and the stringent regulatory products and the stringent regulation environment

also eluded any possibility of development of a derivatives market in country. All Indian

corporate were mainly relying on term lending institution for meeting their project

financing or any other financing requirements and on commercial banks for meeting

working capital finance requirement. Commercial banks are on their assets and liabilities.

The only derivative product they were aware of is the foreign exchange forward contract.

But this scenario changed in the post liberalization period. Conservative Indian business

practitioners began to take a different view of various aspects of their operations to

remain competitive. Financial risks were given adequate attention and �treasury function�

has assumed a significance role in all major corporate since then.

Initially, banks were allowed to pass on gains arising out of cancellation of

forward�s contracts to the customers and customers were permitted to cancel and re-book

the forward contracts. This remarkable change was followed by the introduction of cross

currency forward contacts. But the major milestone in developing forex derivatives

market in India was the introduction of cross currency options. The RBI�s objective of

introducing cross currency options was to provide a complicated hedging strategy for the

corporate in their risk management activities.

The concept of �derivatives� is of course not new to the Indian market. Though

derivatives in the financial markets have nothing to talk about home, in the commodity

markets they have a long history of over hundred years. In 1875, the first commodity

futures exchange was set up in Mumbai under the guidance of Bombay Cotton Traders

Association. A clearinghouse for clearing and settlement of these traders was set

up in 1918. Over a period of twenty years during 1900-1920, other futures markets were

set up in various places. Futures market in raw jute in Kolkata (1912), wheat futures

market in Hapur (1913), and bullion futures market in Mumbai (1920).

When it comes to financial markets, derivatives in equities claim a long existence.

The official history of Bombay Stock Exchange (then known as Native Share and Stock

Brokers Association) reveals that the concept of options existed since 1898 as is reflected

from a quote given by one of the MPs-�India being the original home of options, a native

broker would give a few points to the brokers of the other nations in the manipulation of

puts and calls�.

However, such an early expertise gained by Indian traders in derivatives trading

has come to an end with the Government of India�s ban on forward contract during the

1960�s on the ground of their intrinsic undesirability. But ironically, the same were re-

introduced by the government in the 1980�s as essential instruments for eliminating wide

fluctuations in prices and more so because of the World Bank � UNCTAD report, which

strongly urged the Indian government to start futures trading in major cash crops,

especially in view of India�s entry to WTO.

With the world embracing the derivative trading on large scale, the Indian market

obviously cannot remain aloof, especially after liberalization has been set in motion. Now

we are in the threshold of introducing trading in derivatives, beginning with the stock

index futures to be well set for the introduction of derivative trading. With L.C. Gupta

committee having recently submitted its report on the subject, SEBI is engaged in the

process of assessing the feasibility and desirability of introducing such trading.

The NSE and BSE are two exchanges on which financial derivatives are traded.

The combined notional value of the daily volumes on both the bourses stand at around RS.

150000 cr. In developed markets trading in the derivatives segment are thrice as large as in

the cash markets. In India, the figure is hardly 20% of cash markets. Quite clearly our

derivative markets have a long way to go.

According to the Executive Director of Association of NSE Member of India

(Amni), Vinod Jain, � Volumes in derivatives segment are stagnating due to klack of

growth in the number of markets participants. Besides these products are still to catch up

with the masses who are keeping away from this segment due to lack of understanding

of the products and high contract price�

a) COMMODITIES DERIVATIVES MARKETS

In order to give more thrust on agricultural sector, the National Agricultural

Policy, 2000 has envisaged and domestic market reforms and dismantling of all controls

and regulations in agricultural commodity markets. It has also proposed to extend the

coverage of futures markets to minimize the wide fluctuations in commodity market

prices and for hedging the risk from price fluctuations.

As a result of these recommendations, there are presently, 15 exchanges carrying

out futures trading in as many as 30 commodity items. Out to these, two exchanges viz.

IPSTA, Cochin and the Bombay Commodity Exchange (BCE) Ltd.; have been upgraded

to international exchanged to deal international contracts in peeper and castor oil

respectively. Moreover, permission has been given to two more exchange viz. the First

Commodities Exchange of India Ltd., Kochi (for copra/coconut, its oil and oilcake), and

Keshave Commodity Exchange Ltd., Delhi (for potato), where futures trading started

very recently.

The government has also permitted four exchange viz., EICA, Mumbai. The

Central Gujarat Cotton Dealers Association, Vadodara; The South India cotton

Association Coimbattore; and the Ahmedabad Cotton Merchants Association,

Ahmedabad, for conducting forward (non-transferable specific delivery) contracts in

cotton. Lately as part of further liberalization of trade in agriculture and dismantling of

ECA, 1955 futures trade in sugar has been permitted and three new exchanges viz., E-

Commodities Limited, Mumbai; NCS InfoTech Ltd., Hyderabad; and E-Sugar India.com,

Mumbai have been given approval for conducting sugar futures (Ministry of Food and

Consumer Affairs, 1999).

In the recent past, the GOI has set up a committee to explore and appraise

matters important to the establishment and financing of the proposed national commodity

exchange for the nationwide trading of commodity futures contracts. The usage of

warehouse receipts as a means for delivery of commodities under the contracts is also

being explored. The warehouse receipts system has been operationalized in COFEI

(coffee futures exchange of India) with effect from 1998. The Government of India is on

the move to establish a system of warehouse receipts in other commodity stock

exchanges at various places of the country.

Besides these domestic developments, during 1998, Reserve Bank of India

permitted the Indian Corporate Sector to access the exchanges subject to certain

conditions with a view to enable domestic metal manufacturers to compete with global

players. The de-regulation of oil-imports being on the cards, government should create

the right atmosphere for oil sector to participate in the international oil-derivatives

Markets.

Despite these developments, there are still many impediments that hold back the

farming community from entering the futures market and reap full benefits.

A brief description of commodity exchanges are those which trade in particular

commodities, neglecting the trade of securities, stock index futures and options etc.

In the middle of 19th century in the United States, businessmen began organizing market

forums to make the buying and selling of commodities easier. These central marketplaces

provided a place for buyers and sellers to meet, set quality and quantity standards, and

establish rules of business.

Agricultural commodities were mostly traded but as long as there are buyers and sellers,

any commodity can be traded. In 1872, a group of Manhattan dairy merchants got

together to bring chaotic condition in New York market to a system in terms of storage,

pricing, and transfer of agricultural products.

In 1933, during the Great Depression, the Commodity Exchange, Inc. was established in

New York through the merger of four small exchanges � the National Metal Exchange,

the Rubber Exchange of New York, the National Raw Silk Exchange, and the New York

Hide Exchange.

The major commodity markets are in the United Kingdom and in the USA. In India there

are 25 recognized future exchanges, of which there are three national level multi-

commodity exchanges. After a gap of almost three decades, Government of India has

allowed forward transactions in commodities through Online Commodity Exchanges, a

modification of traditional business known as Adhat and Vayda Vyapar to facilitate better

risk coverage and delivery of commodities. The three exchanges are:

National Commodity & Derivatives Exchange Limited (NCDEX)

Multi Commodity Exchange of India Limited (MCX)

National Multi-Commodity Exchange of India Limited (NMCEIL)

All the exchanges have been set up under overall control of Forward Market Commission

(FMC) of Government of India.

National Commodity & Derivatives Exchange Limited (NCDEX)

National Commodity & Derivatives Exchange Limited (NCDEX) located in Mumbai is a

public limited company incorporated on April 23, 2003 under the Companies Act, 1956

and had commenced its operations on December 15, 2003.This is the only commodity

exchange in the country promoted by national level institutions. It is promoted by ICICI

Bank Limited, Life Insurance Corporation of India (LIC), National Bank for Agriculture

and Rural Development (NABARD) and National Stock Exchange of India Limited

(NSE). It is a professionally managed online multi commodity exchange. NCDEX is

regulated by Forward Market Commission and is subjected to various laws of the land

like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation)

Act and various other legislations.

Multi Commodity Exchange of India Limited (MCX)

Headquartered in Mumbai Multi Commodity Exchange of India Limited (MCX), is an

independent and de-mutulised exchange with a permanent recognition from Government

of India. Key shareholders of MCX are Financial Technologies (India) Ltd., State Bank

of India, Union Bank of India, Corporation Bank, Bank of India and Canara Bank. MCX

facilitates online trading, clearing and settlement operations for commodity futures

markets across the country.

MCX started offering trade in November 2003 and has built strategic alliances with

Bombay Bullion Association, Bombay Metal Exchange, Solvent Extractors� Association

of India, Pulses Importers Association and Shetkari Sanghatana.

National Multi-Commodity Exchange of India Limited (NMCEIL)

National Multi Commodity Exchange of India Limited (NMCEIL) is the first de-

mutualized, Electronic Multi-Commodity Exchange in India. On 25th July, 2001, it was

granted approval by the Government to organise trading in the edible oil complex. It has

operationalised from November 26, 2002. Central Warehousing Corporation Ltd.,

Gujarat State Agricultural Marketing Board and Neptune Overseas Limited are

supporting it. It got its recognition in October 2002.

Commodity exchange in India plays an important role where the prices of any

commodity are not fixed, in an organised way. Earlier only the buyer of produce and its

seller in the market judged upon the prices. Others never had a say. Today, commodity

exchanges are purely speculative in nature. Before discovering the price, they reach to the

producers, end-users, and even the retail investors, at a grassroots level. It brings a price

transparency and risk management in the vital market.

A big difference between a typical auction, where a single auctioneer announces the bids

and the Exchange is that people are not only competing to buy but also to sell. By

Exchange rules and by law, no one can bid under a higher bid, and no one can offer to

sell higher than someone else�s lower offer. That keeps the market as efficient as

possible, and keeps the traders on their toes to make sure no one gets the purchase or sale

before they do. A brief description of commodity exchanges are those which trade in

particular commodities, neglecting the trade of securities, stock index futures and options

etc.

In the middle of 19th century in the United States, businessmen began organizing market

forums to make the buying and selling of commodities easier. These central marketplaces

provided a place for buyers and sellers to meet, set quality and quantity standards, and

establish rules of business.

Agricultural commodities were mostly traded but as long as there are buyers and sellers,

any commodity can be traded. In 1872, a group of Manhattan dairy merchants got

together to bring chaotic condition in New York market to a system in terms of storage,

pricing, and transfer of agricultural products.

b) CURRENCY DERIVATIVES

Foreign exchange derivatives market is one of the oldest derivatives markets in

India. Presently, India has got a well-established dollar-rupee forward market with

contrast traded for one month, two months and three months expiration. Currency

derivatives markets have begun to evolve with the allowing of banks to pass on the gains

upon cancellation of a forward to the customer and permitting customer to cancel and

rebook forward contracts.

Introduction of cross currency options can be considered as another major step

towards developing forex derivatives markets in India.

Today, Indian corporate are permitted to purchase cross currency options to

hedge exposures arising out of trade. Authorized dealers who offer these products have to

necessarily cover their exposure in international markets i.e., they shall not carry the risk

in their own books. Cross currency options are essentially meant for buying or selling

any foreign currency in terms of US dollar. They are therefore, useful only to those

traders who invoice their exports and imports in currencies other than US dollar or for

corporate who borrow in currencies other than US dollar. As against this, majority of

Indian trade is invoiced in the US dollars. Thus, they have almost no relevance in the

Indian context.

Indian banks are allowed to use the foreign currency interest rate swaps, forward

rate agreements/interest rate options/swaps, and forward rate agreements/interest rate

option/swaption/caps/floors to hedge interest rate and currency mismatch in their balance

sheets. Resident and the non-resident clients are also permitted to use the above products

as hedges for liabilities on their balance sheets.

Here it is worth remembering that globally, foreign exchange traders are

becoming as common as stock traders. But in India, forex dealers still play second fiddle

to stock traders and merely meet the needs of the exporters deposits. This may be due to

their risk averting behavior and perhaps lack of proper research. Such being the position

of the forex market, it is too premature to expect that once, foreign currency-Indian rupee

options are introduced, the market will pick up momentum.

This is all the more essential in a market where exchange rates though stated to be

market determined, are often found influenced by RBI�s intervention in the exchange

market. As a result, exchange rate movements hardly obey the principle of interest rate

differentials. The incongruence in the domestic money rates as derived from the

USD/INR forwards yield curve supports this assertion. For example, the one-year

domestic term money is around 6-6.25% whereas that of the one-year implied forward

rate is around 5.40%. In such a scenario, it is difficult for a currency trader to take a firm

view on the exchange rate movement.

c) STOCK MARKET DERIVATIVES

Today trading on the �spot market� for equity in India has always been a futures

market with weekly/fortnightly settlements. These markets features the risks and

difficulties of futures market, But without the gains in price discovery and hedging

services that come with separation the spot market from the futures market. India�s

primary market is acquainted with two types of derivatives�

Convertible bonds

Warrants

As these warrants are listed and traded, it could be said that options market of a

limited sort already exist in our market.

Besides, a wide range of interesting derivatives markets exists in the informal

sector. Contracts such as �bhav-bhav� �teji-mandi� etc. are traded in these markets.

These informal markets enjoy a very limited participation and have their presence outside

the conventional institutions of India�s financial system.

The first step towards introduction of derivatives trading in India in its current

format was the promulgation of the securities laws (Amendment) Ordinance, 1995 that

withdrew the prohibition on options in securities. The real push to derivatives market in

India was however given by the SEBI. The security market watchdog, in November 1996

by setting up a committee under the chairmanship of Dr L C Gupta to develop

�appropriate regulatory framework for derivatives trading in India.�

In 2000, SEBI permitted NSE and BSE to commence trading in index futures

contracts based on S&P CNX Nifty and BSE 30(sensex) index. This was followed by

approval for trading in options based on these two indexes and options on individual

securities. Futures contracts on Individual stocks were launched on November 9,2001.

Trading and settlement is done in accordance with the rules of the respective exchanges.

But the trading volumes were initially quite modest.

This could be due to -----

Initially, few members have been permitted by SEBI to trade on derivatives;

FII�S, MFS have been allowed to have a very limited participation;

Mandatory requirements for brokerage firms to have �SEBI approved-certification-

test-passed� brokers for undertaking derivatives trading� and

Lack of clarity on taxation and accounting aspects under derivatives trading.

The current trading behavior in the derivatives segments reveals that single stock

futures continues to account for sizeable proportion. A recent press report indicates that

futures in Indian exchanges have reached global volumes. One possible reason for such

skewed behavior of the traders could be that futures closely resemble the erstwhile badla

system. Such distortions are not however in the interest of the market.

SEBI has permitted trading in options and futures on individual stocks, but not on

all the listed stocks. It was very selective, stocks that are said to be highly volatile with a

low market capitalization are not allowed for option trading. This act of SEBI is strongly

resented by a section of the market. Their argument is that equity options are

indispensable to investors who need to protect their investment from volatility. The

higher the volatility of a stock the more necessary it is to list options on that stock. They

are highly vocal in arguing that SEBI should design an effective monitoring, surveillance

and risk management system at the level of the exchanges and clearing house to avert and

manage the default risks that are likely to arise owing to high volatility in low market

capital stocks instead of simply banning trading in options on them. SEBI needs to

examine these arguments. It may have to take a stand to nip in the bud all kinds of

manipulations by handling out severe punishments to all such erring companies.

Today, mutual funds are permitted to use equity derivatives products for

�hedging and portfolio rebalancing�. However, such usage is not favored by fund

managers as they strongly apprehend that the dividing line between hedging and

speculation being thin, they may always get exposed to the questioning by the regulatory

authorities.

d) CREDIT DERIVATIVES AND OTHERS

A credit derivative is a financial transaction whose pay-off depends on whether

or not a credit event occurs.

A credit event can be:

Bankruptcy

Default

Upgrade

Downgrade

Interest rate movement

Mortgage defaults

Unforeseen pay-offs

A credit derivative, like any other derivative, derives it�s value from an case is the

credit. In the event of the underlying asset failing to perform as expected, credit

derivatives, ensures that someone other than the principal lender absorbs the resulting

financial loss.

Credit derivatives market in India though could be said as non-existent holds huge

potential. Some of the important factors/situation such as opening up of the insurance

sector to foreign private players, relief to investors, tax benefits to corporate, proxy

hedgers etc., could provide the momentum to the credit derivatives market in India,

boosting yields and bringing down risk for both the corporates and banks.

Secondly, Indian banking system is saddled with huge NPA�s, which it is of

course, eagerly trying to get rid off. The mounting pressure on profitability is making

banks more credit-averse. In such a situation, if markets can offer �credit-insurance� in

the form of derivatives, everyone would jump for it.

TYPES OF OPTIONS

Inboard sense, an option is a claim without any liability. More specifically, an

option is a contract that gives the holder aright, without any obligation, to buy or sell an

asset at an agreed price on or before a specified period of time.

The option to buy an asset is known as a call option and the option to sell an asset

is called a put option. The price at which option is exercised is called an exercise price or

a strike price. The asset on which the call or put option is created is referred to as the

underlying asset. Depending on when an option can be exercised, it is classified as

follows:

European Option: When an option is allowed to exercise only on the

maturity date, it is called a European Option.

American Option: When an option can be exercised any time before its

maturity is called an American Option.

Capped Option: When an option is allowed to exercise only during a

specified period of time prior to its expiration unless the option reaches the

cap value prior to expiration in which the option is automatically exercised.

The holder of an option has to pay a price for obtaining a call or put option. The

price will have to be paid whether the holder exercises his option and it is called option

premium.

Option Terminology

There are several important terms used in option they are: -

1) Call option: - Gives the buyer the right, but not the obligation to buy a specific

futures contract at a predetermined price within a limited period of time.

A call option is a contract, which gives the owner the right to buy an asset for a

certain price on or before a specified date. For example, if you buy a call option on a

certain share of XYZ Company, you have the right to purchase 100 shares (assuming of

course, that the option involves 100 shares).

Suppose current share price (S) of Reliance Industries is Rs. 291. You expect that

price in a three months period will go up Rs. 300. But you also fear that the price may

also fall below Rs. 291. To reduce the chance of risk and at the same time to have the

opportunity of making profit, instead of buying the share, you can buy a 3-month call

option on Reliance Industries at an agreed exercise price (E) of, say, RS.280. Ignoring the

option premium, taxes, transaction costs and the time value of money, the decision to

exercise your option depends upon the share price after three months. You will exercise

option when the share price after three months is above Rs. 280 and you will not exercise

when the share price after three month is below Rs. 240.

Thus option should be exercised when:

Share price at expiration > Exercise price = St>E

Do not exercise option when:

Share price at expiration <= Exercise price =St<E

The value of call option at expiration is:

Value of call option at expiration= Maximum [(share price �exercise price), 0]

Ct = Max [(St � E), 0]

The expression above indicates that the value of call option at expiration is the

maximum of the share price minus the exercise price and zero. The call option holder�s

opportunity to make profit is unlimited. It depends on the actual market price of the

underlying share when the option is exercised. Greater the market value of the underlying

asset, the larger is the value of the option. The following figure shows the value of call

option.

For the call option writer, he will gain when share price is below the strike price

and will lose when stock price is above the strike price. The call buyer�s gain is call

seller�s loss. The figure 1.2 shows the pay-off of a call option writer.

2) Put option: - Gives the buyer the right, but not the obligation, to sell a specific

futures contract at a predetermined price within a limited period of time.

Put option is a contract that gives the holder a right to sell specified shares at an

agreed price on or before a given maturity. Thus, if you buy a put option on shares of

XYZ Company, you have the right to sell 100 shares of this company at the specified

price at any time between today and the specified date.

Suppose the current price (S) of Reliance Industries is Rs. 291 and you expect that

the price will fall within a three months. Therefore, you can buy a 3-month put option on

Reliance Industries at an agreed exercise price (E), say, Rs. 295. If the price actually falls

to (St) Rs. 280 after three months, you will exercise your option. You will buy the share

for Rs. 280 from the market and deliver it to the put-option writer to receive Rs. 295.

Your gain is Rs.15 ignoring the put option premium, transaction cost and taxes. You will

not exercise if the share price rises above exercise price; the put option is worthless and

its value is zero.

Thus, exercise the put option when

Exercise price >Share price at expiration = E > St

Do not exercise put option when

Exercise price <=Share price at expiration = E<St

The value of put option at expiration will be

Value of put option at expiration= Maximum [(Exercise price �Share price), 0]

Pt = Max [(E-St), 0]

The put option buyer�s gain is the seller�s loss. The potential loss of the put option

is limited to the exercise price. Since the buyer has to pay a premium to the seller for

purchasing a put option, the potential profit of the buyer and the potential loss of the

seller will reduce by the amount of premium.

Combination Puts and calls represent basic options. They serve as a building for developing more complex options. The algebra corresponding to combination of buying option and equity stock is as follows: Pay -offs just before expiration date If St< E If St > E 1) Put option E � S1 0 2) Equity stock S1 S1

= Combination E S1 Thus if you buy a stock with a put option on that stock (exercisable at price E), your

payoff will be E if the price of the stock is less that E, otherwise your payoff will be S1.

Consider a more complex combination that consists of

1. Buying stock 2. Buying a put option on that stock and 3. Borrowing an amount equal to the exercise price.

The payoff from this combination is identical to the payoff from buying a call option. The algebra of this equivalence is shown as follows: Pay �off just before expiration date If S1< E If S1 >E 1) Buy the equity stock S1 S1 2) Buy a put option E-S1 0 3) Borrow an amount equal To exercise price -E -E (1) + (2) + (3) = Buy a call option 0 S1-E

If C1 is the terminal value of the call option (remember that C1 = Max (S1-E, 0), P1 the terminal value of the put option (remember that P1= Max (E-S1, 0), S1 the price of the stock, and E the amount borrowed, then we have C1= S1+P1-E This is referred to as the put �call parity.

3) Holder: - The buyer of the option.

4) Premium: -The amount paid by the buyer of the option to the seller.

5) Writer: - The option seller.

6) Strike price: -The predetermined price at which a given futures contract bought or

sold. Also called the �exercise price� these levels are set at regular intervals.

7) At-the money: - An option is at-the money when the underlying futures price equals or

nearly equals, the strike price.

For e.g.: - A T-bond Put or Call option is at-the-money if the option strike

price is at 78 and the price of the T-Bond futures contract is at or neat 78.00

8) In-the money: - A call option is in-the money when the underlying futures price is

greater than the strike price.

For e.g.: - If T-Bond futures are at 80.00 and the T-Bond call option strike price

is 78.00, the call is in-the money

Where as the put option is in-the money when the strike price of the option is

greater than the price of the underlying futures contract.

For e.g.: - If the strike price of the put option is 80.00 and T-Bond futures are

trading at 77.00 the put option is in- the money

9) Out-of-the money: - A call option is out-of-the money if the Strike price is greater than

the underlying futures price. For e.g.: - if T-Bond futures are at 80.00 and the

T-Bond call option strike price is 82.00 the option is out-of-the money.

The put option is out-of-the money if the underlying futures price is

greater than the strike price

For e.g.: - if T-Bond futures are at 77.00 and the T- Bond put option strike

price is 76.00 the put option is out-of-the money.

Futures > strike

Futures < strike

Futures = strike

Futures = strike

Futures < strike

Futures > strike

At-the money

Out-of-the money

In-the money

Call option Put option

Factors Determining the Option Value: The precise location of the option value depends on five key factors: Exercise price Expiration date Stock price Stock price variability Interest rate

Exercise Price: Other things being constant, higher the exercise price, the lower the

value of call option. It should be remembered that the value of call option could never be

negative; regardless of how high the exercise price is set.

Expiration Date:

Other things being constant, the longer the time to expiration date, the more

valuable the call option. Consider two American calls with maturities of one year and two

years. The two-year call obviously is more valuable than one-year call because it gives its

holder one more year within which it can be exercised.

Stock Price: The value of a call option, other things being constant, increases with the

stock price.

Stock Price Variability: A call option has value when there is possibility that the stock

price exceeds the exercise price before the expiration date. Other things being equal, the

higher the variability of the stock price, the greater the likelihood that stock price will

exceed the exercise.

REASONS FOR USING OPTIONS

The reasons for using options on futures are reflected in the structure of an option

contract.

1) An option, when purchased gives the buyer the right, but not the obligation, to

buy or sell a specific amount of a specific commodity at a specific price within a

specific period of time.

2) The decision to exercise the option is entirely that of the buyer.

3) The purchaser of the options can lose no more than the initial amount of money

invested (premium).

4) An option buyer is never subject to margin calls. This enables the purchaser to

maintain a market position, despite any adverse moves without putting up

additional funds.

MOTIVES for BUYING and SELLING OPTIONS

One may be buyer or seller of call or put option for a variety of reasons.

A call option buyer for e.g. is bullish that he is or she believes the price of the underlying

futures contract will rise. If price do rise, the call option buyer has three course of action

available.

First is to exercise the option and acquires the underlying futures contract at the strike

price

Second is to offset the long call position with a sale and realize a profit.

Third is to let the option expires worthless and forfeit the unrealized profit.

The seller of the call option expects futures prices to remain relatively stable or to

decline modestly. If prices remain stable, the receipt of the option premium enhances the

rate of return on a covered position. If prices decline, selling the call against a long

futures position enables the writer to use the premium as a cushion to provide protection

to the extent of the premium received. For instance, if T-bond futures were purchased at

80.00 and call option with an 80.00 strike price were sold for 2.00, T-bond futures could

decline to the 78.00 levels before there would be a net loss in the position.

However, T-bond futures rise to 82.00 the call option seller forfeits the opportunity for

profit because the buyer would likely exercise the call against him and acquire a future

position at 80.00(strike price).

The perspective of the put buyer and put seller are completely different. The

buyer of the put option believes for the underlying futures will decline for e.g.: - if a T-

Bond put option with a strike price of 82.00 is purchased for 2.00 while T-Bond futures

also are at 82.00, the put option will be profitable for the purchaser to exercise if T-Bond

futures decline below 80.00

MMEETTHHOODDOOLLOOGGYY

TYPE OF RESEARCH

The type of research is selected on the basis of problems identified. Here the research

type used is descriptive research. Descriptive research includes fact-findings and

enquiries of different kinds. The major purpose of descriptive research is a description of

the state of affairs, as it exists in the present system. In this dissertation an attempt has

been made to discover various issues related to derivatives in the Indian market and how

they help the hedge the risk.

ACTUAL COLLECTION OF DATA

Data Collection from secondary Sources

Secondary data were gathered from numerous sources. While preparation of this

project report, the secondary data have been collected through:

Data was generated from general library research sources, textbooks,

trade journals, articles from newspaper, treasury management, brochures,

interviews with different brokers of Bangalore stock Exchange and

Internet web site

www.nseindia.com

www.sherkhan.com

www.icfai.org

www.google.com

www.commodityindia.com

PPRREESSEENNTTAATTIIOONN AANNDD AANNAALLYYSSIISS

Derivatives in India: A chronology

14 December 1995 NSE asked SEBI for permission to trade index futures.

18 November 1996 setup L.C. Gupta Committee to draft a policy framework

for index futures.

1 May 1998 a Committee submitted report.

7 July 1999 RBI gave permission for OTC forward rate agreement (FRAs)

and interest rate swaps.

24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian

index.

25 May 2000 SEBI gave permission to NSE and BSE to do index futures

trading.

9 June 2000 Trading of BSE Sensex futures commenced at BSE.

12 June 2000 Trading of Nifty Index Futures commenced at NSE.

25 September 2000 Nifty Futures trading commenced at SGX.

In July 2001 Trading of Nifty index Options and Stock Options commenced at

NSE.

In Nov 2001 trading of stock Futures commenced at NSE.

Trading Mechanics in Indian Derivatives Market

a) Spot market

In a spot market transactions are settled �on the spot�. Once a trade is agreed

upon, the settlement- i.e. the actual exchange of money for goods takes place with

minimum possible delay.

There are two real-world implementations of a spot market. Rolling settlement

and real time gross settlement (RTGS). With rolling settlement trades are netted through

one day, and settled x working days later; this is called T+X rolling settlement. For

example: with T+5 rolling settlement, traders are netted through Monday, and the net

open position as of Monday evening is settled on the coming Monday. Similarly, traders

are netted through Tuesday, and settled on the coming Tuesday.

With RTGS, all trades settle in a few seconds with no netting. Rolling settlement

is a close approximation and RTGS is a true spot market.

b) Forward transaction

In a forward contract, two parties irrevocably agree to settle a trade at a future

date, for a stated price and quantity. No money changes hands at the time the trade is

agreed upon.

Suppose a buyer L and seller S agrees to do a trade in 100 grams of gold on 31

Dec 2002 at Rs. 10,000/tola. Here, Rs. 10,000/tola is the �forward price of 31 Dec 2005

Gold�. The buyer L is said to be long and the seller S is said to be short. Once the

contract has been entered into, L is obligated to pay S Rs. 10, 00,000 on Dec 31, 2005,

and take delivery of 100 tolas of gold. Similarly S is obligated to be ready to accept

Rs.10, 00,000 on 31 Dec, and give 100 tolas of gold in exchange.

c) Exchange traded versus OTC derivatives

Derivatives, which trade on an exchange, are called �exchange-traded�. Trades on

the exchange generally take place with anonymity. Traders at an exchange generally go

through the clearing corporation.

A derivative contract that is privately negotiated is called OTC derivatives. OTC

trades have no anonymity, and they generally do not go through a clearing corporation.

Every derivative product can either trade OTC (i.e. through private negotiation) or on an

exchange. In one specific case the jargon demarcates this clearly: OTC futures contracts

are called �forwards� (or, exchange-traded forwards are called �futures�). In other cases,

there is no such distinguishing notation. There are �exchange-traded options� as opposed

to �OTC options�; but both are called options.

d) Carry forward

Badla is a mechanism to avoid the discipline of a spot market; to do trades on the

spot market but not actually do settlement. The �carry forward� activities are mixed

together with the spot market. A well functioning spot market has no possibility of carry-

forward. Derivatives trades take place distinctively from the spot market. The spot price

is separately observed from the derivative price. A modern financial system consists of a

spot market, which is a genuine spot market, and a derivatives market is separate from

the spot market.

e) Intermediation in Indian derivatives market

There are two kinds of brokerage firms on the index futures market: trading

members (TMs) and clearing members (CMs). NSCC only deals with clearing members:

NSCC bears the full of default by a clearing member. Trading members obtain the right

to trade through a clearing member; the CM adopts the full credit risk of the TM. If a TM

fails, NSCC holds the relevant CM responsible.

f) Margin Money

The aim of margin money is to minimize the risk of default by either

counter-party. The payment of margin ensures that the risk is limited to the previous

day�s price movement on each outstanding position. However, even this exposure is

offset by the initial margin holdings. Margin money is like a security deposits or

insurance against a possible future loss of value.

There are different types of margin like: -

Initial margin

The basic aim of initial margin is to cover the largest potential loss in one day.

Both buyer and seller have to deposit margins. The initial margin is deposited before the

opening of the position in the futures transaction.

Mark to Market Margin

Mark to market margin is collected in cash for all futures contracts and adjusted

against the available liquid net worth for option position. In the case of futures contracts

mark to margin may be considered as mark to market Settlement. All daily losses must be

met by depositing of further collateral known as variation margin, which is required by

the close of business, the following day. Any profits on the contract are credited to the

client�s variation margin account.

Maintenance margin

Some exchanges work on the system of maintenance margin, which is slightly

less than initial margin. The margin is required to be replenished to the level of initial

margin, only if the margin level drops below the maintenance margin limit.

Trading

NSE introduced for the first time in India, fully automated screen based trading. It

uses a modern, fully computerised trading system designed to offer investors across the

length and breadth of the country a safe and easy way to invest.

The NSE trading system called 'National Exchange for Automated Trading' (NEAT) is a

fully automated screen based trading system, which adopts the principle of an order

driven market.

Trading System

The Futures and Options Trading System provides a fully automated trading

environment for screen-based, floor-less trading on a nationwide basis and an online

monitoring and surveillance mechanism. The system supports an order driven market and

provides complete transparency of trading operations.

Orders, as and when they are received, are first time stamped and then immediately

processed for potential match. If a match is not found, then the orders are stored in

different 'books'. Orders are stored in price-time priority in various books in the following

sequence:

Best Price

Within Price, by time priority.

Trading on the derivatives segment takes place on all days of the week (except Saturdays

and Sundays and holidays declared by the Exchange in advance).

Trading Locations

Till the advent of NSE, an investor wanting to transact in a security not traded on

the nearest exchange had to route orders through a series of correspondent brokers to the

appropriate exchange. This resulted in a great deal of uncertainty and high transaction

costs. One of the objectives of NSE was to provide a nationwide trading facility and to

enable investors� spread all over the country to have an equal access to NSE.

NSE has made it possible for an investor to access the same market and order book,

irrespective of location, at the same price and at the same cost. NSE uses sophisticated

telecommunication technology through which members can trade remotely from their

offices located in any part of the country. NSE trading terminals (F&O segment) are

present in various cities and towns all over India.

Types of traders in a derivatives market Hedgers, speculators and arbitrators are the types of traders in derivatives market. Hedgers: Hedgers are those who protect themselves from the risk associated with the price of an

asset by using derivatives. A person keeps a close watch upon the prices discovered in

trading and when the comfortable price is reflected according to his wants, he sells

futures contracts. In this way he gets an assured fixed price of his produce.

In general, hedgers use futures for protection against adverse future price movements in

the underlying cash commodity. Hedgers are often businesses, or individuals, who at one

point or another deal in the underlying cash commodity.

Take an example: A Hedger pays more to the farmer or dealer of a produce if its prices

go up. For protection against higher prices of the produce, he hedges the risk exposure by

buying enough future contracts of the produce to cover the amount of produce he expects

to buy. Since cash and futures prices do tend to move in tandem, the futures position will

profit if the price of the produce rise enough to offset cash loss on the produce.

Speculators: Speculators are somewhat like a middleman. They are never interested in actual owing

the commodity. They will just buy from one end and sell it to the other in anticipation of

future price movements. They actually bet on the future movement in the price of an

asset.

They are the second major group of futures players. These participants include

independent floor traders and investors. They handle trades for their personal clients or

brokerage firms.

Buying a futures contract in anticipation of price increases is known as �going long�.

Selling a futures contract in anticipation of a price decrease is known as �going short�.

Speculative participation in futures trading has increased with the availability of

alternative methods of participation.

Speculators have certain advantages over other investments they are as follows:

If the trader�s judgment is good, he can make more money in the futures market faster

because prices tend, on average, to change more quickly than real estate or stock prices.

Futures are highly leveraged investments. The trader puts up a small fraction of the value

of the underlying contract as margin, yet he can ride on the full value of the contract as it

moves up and down. The money he puts up is not a down payment on the underlying

contract, but a performance bond. The actual value of the contract is only exchanged on

those rare occasions when delivery takes place.

Arbitrators:

According to dictionary definition, a person who has been officially chosen to

make a decision between two people or groups who do not agree is known as Arbitrator.

In commodity market Arbitrators are the person who takes the advantage of a

discrepancy between prices in two different markets. If he finds future prices of a

commodity edging out with the cash price, he will take offsetting positions in both the

markets to lock in a profit. Moreover the commodity futures investor is not charged

interest on the difference between margin and the full contract value

TABLE 1: THE GLOBAL DERIVATIVES INDUSTRY:

CHRONOLOGY OF INSTRUMENTS

Table 2: DERIVATIVES TRADING VOLUME AT �NSE�

FROM OCT-05 TO MARCH-06

1874 Commodity futures

1972 Foreign currency futures

1973 Equity options

1975 T-bond futures

1981 Currency swaps

1982 Interest rate swaps; T-note futures; Eurodollar

futures; Equity index futures; Options on T-bond

futures; Exchange�listed currency options

1983 Options on equity index; Options on T-note futures;

Options on currency futures; Options on equity

index

Futures; Interest rates caps and floors

1985 Eurodollar options; Swaption

1987 OTC compound options; OTC average options

1989 Futures on interest rate swaps; Quanto options

1990 Equity index swaps

1991 Differential swaps

1993 Captions; Exchange-listed FLEX options

1994 Credit default options

Particulars

Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06

Stock futures

214398 216526 280283 265042 288715 473251

Index Futures

170100 135478 183293 166127 156359 192035

Stock Options

13575 12777 17244 17893 15268 22466

Index Options

35586 31073 42987 38521 32331 47097

Graph1 Showing the Derivatives trading volume at NSE from Oct 2005

to Mar 2006

Derivatives trading Volume

214398 216526

280283265042

288715

473251

170100

135478

183293

166127156359

192035

13575 12777 17244 17893 1526822466

35586 3107342987 38521

32331

47097

0

50000

100000

150000

200000

250000

300000

350000

400000

450000

500000

Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06

Vo

lum

e (

Rs

Cr)

stock Futures Index Futures

Stock Options Index Options

Table Showing trading Contracts from Oct 2005 to Mar 2006

Particulars Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06

stock Futures

6526919 6252736 7571377 7134199 7443178 10844400 Index

Futures 6844732 5238175 6613032 5760999 5186835 5952206

Stock Options

389254 364188 456529 456055 401973 537261 Index

Options 1410519 1200557 1540180 1330466 1066396 1456351

Graph2 Showing the Derivatives trading Contracts at NSE from Oct 2005 to Mar

2006

Derivatives Contracts

6844732

5238175

6613032

5760999

5186835

5952206

389254 364188 456529 456055 401973537261

14105191200557

15401801330466

1066396

1456351

65269196252736

7571377

7134199

7443178

10844400

0

1000000

2000000

3000000

4000000

5000000

6000000

7000000

8000000

9000000

10000000

11000000

Oct-05 Nov-05 Dec-05 Jan-06 Feb-06 Mar-06

No

of C

ontra

cts

Index Futures Stock Options

Index Options stock Futures

Graph3 Showing the Derivatives trading volume at NSE of Oct 2005

Derivatives Trading Volume at NSE of Oct 05

214398

170100

13575

35586

0

50000

100000

150000

200000

250000

Stock Futures Index Futures Stock Options Index Options

Derivatives

Vol

ume

(Rs

Cr)

Graph4 Showing the Derivatives trading volume at NSE of Nov 2005

Derivatives trading volume At NSE of Nov

05

Index Options, 31073

Graph5 Showing the Derivatives trading volume at NSE of Dec 2005

Derivatives Trading Volume at NSE of Dec 05

280283

183293

17244

42987

0

50000

100000

150000

200000

250000

300000

Stock Futures Index Futures Stock Options Index Options

Derivatives

Volum

e (R

s Cr)

Graph6 Showing the Derivatives trading volume at NSE of Jan 2006

Graph7 Showing the Derivatives trading volume at NSE of Feb 2006

Derivatives Trading Volume at NSE of Jan 06

Stock

Options,

17893

Index

Options,

38521

Stock

Futures,

265042

Index Futures,

166127

Derivatives Trading Volume At NSE of Feb 06

288715

156359

1526832331

0

50000

100000

150000

200000

250000

300000

350000

Stock Futures Index Futures Stock Options Index Options

Derivatives

Vol

ume

(Rs

Cr)

Graph8 Showing the Derivatives trading volume at NSE of Mar 2006

Derivatives Trading Volume At NSE of Mar 06

473251

192035

2246647097

0

50000

100000

150000

200000

250000

300000

350000

400000

450000

500000

Stock Futures Index Futures Stock Options Index Options

Derivatives

Voi

ume

(Rs

Cr)

Growth of Derivative Market in India

Table showing the turn over of various derivatives in Indian market

Particulars 2002-03 2003-04 2004-05

2001-02

Index Futures 21482 43952 554446 772147 Stock Futures 51516 286533 1305939 1484056 Index Options 2466 5669 31794 69371 stock Options 18780 69643 167967 132054

Growth of derivatives market

21482 43952

554446

772147

51516

286533

13059391484056

2466 5669 31794 6937118780 69643167967 132054

0250000500000750000

1000000125000015000001750000

2001-02 2002-03 2003-04 2004-05

Year

Tur

n O

ver

Index Futures Stock Futures

Index Options stock Options

ROLE OF DERIVATIVES IN INDIAN ECONOMY

Benefits that acquire to the Indian capital markets and the Indian economy from

derivatives are discussed here.

Derivatives will make possible hedging which otherwise is infeasible this is

illustrated by the dollar-rupee forward market. Imports and exports used to take place in

the country under the presumption that importer and exporters have to bear currency risk.

To the extent that importers and exporters are risk averse, the existence of this risk would

lead them to do international trade in smaller quantities than they have liked to. Once the

dollar-rupee forward market came about, importers and exporters could hedge themselves

against currency risk. Today the use of such hedging is extremely common amongst

companies that are exposed to currency risk. This hedging facility has definitely helped

importers and exporters do international trade in larger quantities than before. The RBI�s

permission for the dollar-rupee forward market is therefore part of the explanation for the

enormous growth in imports and exports that has taken place in the last five years.

Similarly, on the equity market, many retail investors who are uncomfortable

about the equity market would enter if they were given the alternative of buying

insurance, which controls their downside risk. This would enhance the action of the

savings of the country, which are routed through the equity market. The same would be

the case with international investors, who would place limit orders. These improvements

in the quality of the underlying market have been observed across a variety of research

studies done on foreign markets, which have compared market quality before

introduction of derivatives as compared with after.

a) Development of India�s financial industry

Today, derivatives are a major part of the global financial system. If India is

able to swiftly develop competence in the derivatives area, then there is an enormous

opportunity for India as a center of international finance. One of the largest futures

market on Japan�s Nikkei 225 index, today, is in Singapore. In that same sense, it is quite

possible for Indian markets to be trading derivatives on underlying price, which are not

from India. This would bring revenues into India�s financial industry and help enhance

India�s integration into the world economy.

Conversely, if India does not develop such markets locally, the derivatives

market in the Indian instruments might develop outside India that will undermine the

regulatory framework under which other Indian markets work. In addition, Indian

investors who cannot access such off-shore markets will be denied the benefits of

advance risk hedging mechanism putting them at disadvantage be able to enhance the

fraction of their portfolio that they allocate to India once hedging instruments become

available.

Derivatives will enable a clear separation between speculators who wish to

bear risks versus hedgers who wish to buy insurance services. Today speculators

act on the cash market, which generates its own difficulties. With derivatives

market it will be possible for risk to be transferred to the people who are most apt

to bear it, and to do all these activities away from the basic cash market.

Derivatives will lead to an improvement in the quality of the cash market.

The liquidity and market efficiency of the underlying cash market will improve

once derivatives come about the causality underlying this transformation of the

quality of the underlying market is as follows: -

Derivatives markets will move some of the noise traders in the present

speculation securities away from the cash market. Due to this shift, it is expected that the

volatility of the cash market instrument will reduce. It is generally believed that

derivatives will improve the quality of information production and analysis, by giving

higher profit rates to people who successfully understand valuation. Similarly, it is

expected that derivatives will lead to multi-crore arbitrage markets with arbitrageurs who

constantly close small mis-pricings between the derivatives and the cash market. Due to

the very nature of arbitrage business to attain risk free position, such arbitrage will be

liquidity demanding. This irreversibility arises because once a market is well established;

it is difficult to get it to move. For example, Japanese regulators know more about

financial economies today, but the Nikkei 225 market is still in Singapore.

That could easily happen to India�s derivatives market also. Market prices for

India�s market are available worldwide through information vendor feeds such as

Reuters, knight-ridder etc. and there is nothing preventing an exchange in other country

from having options and futures on any Indian underlying. If the derivatives markets on

Indian underlying move offshore, it would be unfair to Indian citizens who would be

unable to access these markets under the present regime of barriers to international flows

of funds.

b) Challenges

The challenges in today�s context for starting the derivatives market is to

foster the development of strong, healthy and vibrant derivatives industry, which

compliments the securities, market existing in the country. The pressure for an early

development of India�s derivatives is two fold:

To the extent that India�s economy lives for one more year without

derivatives, it hinders the economic progress of the country. For example,

if the dollar-rupee forward market had come about sooner, then India�s

imports and exports might have seen higher growth much before.

If Indian markets do not develop derivatives quickly, the markets for

derivatives of Indian instrument will move offshore. In derivatives,

competition amongst markets from all over the world to obtain trading

volume from innovations in contract design is fierce.

BENEFITS AND RISK ASSOCIATED WITH DERIVATIVES

Economic function of derivatives

Derivatives play the following important roles in every economy where they are traded.

Price discovery and planning

Prices of an organized derivatives market reflect the combined views and

perception of buyers and sellers, not only of the current demand and supply, but also of

their expiration. At the time of expiration the prices of derivatives converge with the

price of the underlying assets. This process of price discovery is applicable to both

futures and options. Information generated by futures trading through price discovery

process helps in planning of all users at every stage. To the extent that these markets

improve planning and efficiency as well as reduce operating costs, benefits will accrue to

consumers in the economy.

Risk shifting

The derivative market allows and facilitates risks to be transferred from those who

have them but may not want them. The risk in case of derivatives is primarily price risk.

This risk represent a cost, which must be borne by someone if the dealer, lender,

borrower, merchant or middlemen has to assume risk, then they will pay the opposite

party less or charge them more or a combination of the two. If the risk is assumed directly

by the dealer or merchant they are compensated for bearing the risk.

Numerous general economic benefits flow from the risk shifting of hedging

function. These include reduced finance charges in carrying inventory of all kinds

including portfolio of investments. The larger banks that finance producers, distributors

and processors give their best terms for the value of the inventory that is fully protected

by an adequate hedge.

Enhance liquidity in the underlying markets

Derivatives due to their inherent nature are linked to the underlying cash markets.

It has been observed the world over that introduction of derivatives increases the trading

volume in the underlying. Markets players reluctant to participate due to the absence of

risk shifting mechanism can now participate in the cash market. Interplay between the

underlying derivatives market generates additional activity in the underlying market

increasing liquidity in the underlying.

Shifts the speculative trading to a more controlled

environment

In the absence of an organized derivatives market, speculators operate in the

underlying cash markets. This acts as an establishing factor for the underlying marker

since the underlying market act also as proxy futures and options market. Margining,

monitoring and surveillance of the activities of the various participants is difficult in

these kind of mixed markets. Derivatives market provides a mechanism for the

speculators to be identified separately and surveillance of these participants and their

positions can be done in a better manner. This reduce imbalance in the underlying

markets. Thus the derivatives markets will help in controlling the activities of speculators

and reduce the risks now prevalent in the underlying securities market in India.

FINDINGS AND CONCLUSION

FINDINGS AND SUGGESTIONS

Some of the few suggestions are as follows: -

Regulations should be transparent and subject the same disclosure standards as

those applying to other participants in the financial markets. Tough after the

commencement of the commodity market in India it has become transparent to

some extent, more transparency is required.

Increase the limits on trading of derivatives by foreign institutional investors.

Increase the number of stocks on which options and futures are traded.

Contact size at NSE is 100 decided by SEBI

SEBI should promote the use of the derivatives and educate the investors on how

derivatives can reduce risk if used widely.

Availability of futures on all agricultural commodities would boost private sector

participation in sourcing agricultural produce from villages and transport them

across the country as also store them to transport across the time or period. This in

turn helps mitigate the crisis emanating from the vagaries of monsoon.

Indian currency derivatives market is basically an Over The Counter (OTC)

market. It suffers from poor participation from corporate, and fewer market

makers. It therefore, calls for increased product familiarization, market

participation and development of supporting regulation, legal and tax framework.

There is a need to establish research wings in all major banks for predicting

intraday and short-term movements in the exchange rate so that traders can

initiate deals with confidence.

CONCLUSION

The basic function of a financial system is to "facilitate the allocation and

development of economic resources, both intertemporarily and across time, in an

uncertain environment". Risk is therefore an inherent feature of every financial decision.

In that context, derivative products offer a means to transfer the risk inherent to financial

decisions. Derivatives trading also add to the market completeness. Trading in derivatives

also facilitates price discovery of the underlying cash securities via information

dissemination. Besides these economic benefits, derivatives, like any other financial

instruments, contain certain risks such as market risk, credit risk etc. Therefore, the

consensus is that if used properly, derivatives can be a valuable risk management tool but

strict monitoring is needed to prevent (as far as possible) their perceived `misuse' for

speculative purposes.

While the very core of derivative products is to manage risk, it is important to

appreciate that all derivatives are highly geared, or leveraged, transactions.

Traders/investors are able to assume large positions - with similar sized risks - with very

little up-front outlay and the risk to the investor is high. A thorough grasp of product

technicalities is only one aspect of the knowledge and skills that traders require. Every

trader has a view of the market and their end objective is, of course, profit from that view.

And the most effective route to achieving this is to form a view that proves to be correct;

having positioned one's self to obtain the maximum profit from it. If a trader has a bullish

he could go long in the futures market or choose to purchase a call option.

Since derivatives also suffer from risk, as do the underlying securities, derivatives

need to be handled cautiously on account of sheer size. These characteristics make

derivatives double-edged swords. This drives home the importance of adequate

regulation that care of the concerns associated with derivatives trading.

Increase in companies listed on stock exchanged emergence of securities and

exchange board of India (SEBI) as truly national level securities regulator, free pricing

of public issues, screen based trading system, more than six times increases in turnover

the stock exchanges, emergence of self regulatory organization in the fields of merchant

banking, mutual funds, emergence of investor associations, implementation of trade

guarantees besides others.

SEBI�S consistent efforts at improving the market infrastructure, providing level

playing field and ensuring transparent, fair and efficient trading at stock exchanges have

started to yield beneficial results. Depository legislation has also been approved by the

parliament and depository operations have commenced. In the four years. SEBI has

consistently tried to bring in international practices approval granted for setting up

derivatives market is a big step to bring Indian capital markets. Increased sophistication

of capital market participants and the need of market participants for risk hedging

instruments are strong factors in favor of derivatives market in India.

To summarize the role of regulation is the cushion and help other market

monitoring mechanism such as competition or reputation to maintain a fair and orderly

financial markets in which innovation is encouraged. Its objective is thus to support and

encourage all the necessary structural changes in the products or institutions architecture

that allows market participants to increase the benefits extract from the economic

functions of derivatives at controlled risk levels. Thus, one could view the role of

regulation as that of a player of last resort that guarantees that the economic benefits

associated to the derivative trading activity remains on the efficient �risk/return� frontier.

Terminologies

OTC : Over the counter

SEBI : Securities Exchange Board of India

CBOT : Chicago Board of Trade

CBOE : Chicago Board Option Exchange

NSCC : National securities clearing Corporation

TM : Trading members

CM : Clearing members

NEAT : National Exchange for Automated Trading

F& O : Futures & Option

FUTINX : Futures Index

FUTSTK : Futures Stock

OPTIDX : Option Index

OPTSTK : Option Stock

FUTINT : Future Interest

NSE : National Stock Exchange

BSE : Bombay stock Exchange

NYSE : New York Stock Exchange

COFEI : Coffee Futures Exchange of India

NCDEX : National Commodity & Derivatives Exchange of India

MCX : Multi Commodity Exchange Of India Limited

NMCEIL : National Multi Commodity Exchange Of India Limited

FMC : Forward market Commission

NABARD : National Bank For Agriculture & Rural Development

NPA : Non-Performing Assets

FRA : Forward rate agreements

RTGS : Real time Gross Settlements